February 18, 2009—The current distress of large international banks in the US and Europe is spurring a rethinking of banking system regulations both in rich countries and in emerging markets.

Asli Demirguc-Kunt, Senior Research Manager for Finance and Private Sector Development in the World Bank’s Development Research Group, offers her thoughts on some of today’s most pressing questions.

Q. When a financial crisis like this happens, what is the first thing to do?

ADK. The first thing is to “contain” the crisis and quickly restore confidence. In the containment stage, central banks need to lend quickly, to avoid a liquidity crisis that will undermine sound institutions.

But at the same time, long term goals should not be discarded, because the manner in which crises are resolved affects the frequency and depth of future crises.

If institutions perceive that they can count on being bailed out during crises, they will be more willing to risk insolvency in future—creating a so-called moral hazard.

Research suggests that providing indiscriminate and unlimited liquidity and blanket guarantees during crises seldom speeds recovery. On the contrary, it is associated with greater output loss and increases the ultimate fiscal costs of a bailout.

Presumably this is because these policies divert attention from the real problem, and delay healthy restructuring and exits that need to take place.

So it is important for governments to distinguish between deeply insolvent banks and others that are solvent enough to be salvageable. As we have seen, information problems may make this very difficult.

That’s why regulators must identify and remedy gaps in information well in advance, recognize the reduction in transparency that often comes with financial engineering and regulatory arbitrage, and nip the problems in the bud by demanding improvements.

Crisis preparedness also helps—authorities need to establish and regularly test a well-publicized benchmark plan for dealing with crises—that is, play “war games.”

Q. How do we really fix the problem? What can governments do to encourage the recovery of the banking system?

ADK. After the crisis is contained, the most important thing is to deal with widespread undercapitalization and insolvencies. Banks need to be recapitalized for the recovery process to begin.

As we have seen, this process can leave governments as owners or temporary caretakers. But any government involvement should protect the interests of the taxpayers, impose losses on responsible parties, and use the private sector to identify winners and losers—for example, by insisting that a share of new capital comes from the private sector.

Any plan that purchases bad assets from troubled financial institutions or recapitalizes without extracting some claim from the institutions amounts to a transfer from taxpayers to shareholders—again undermining market discipline.

We have learnt from past crises that governments don’t make good bankers, so any viable restructuring plan needs to design an exit plan for the public sector. Ideally, after the resolution stage, the banks should be well-capitalized and in private hands once again.

Q. We hear often about a credit freeze. What can be done to get banks to lend again?

ADK. Of course the first thing is to make sure the banks are well capitalized, which should lay the ground for future recovery of credit. But we know from past crises that output recovery almost always comes before credit recovery.

In a paper that I wrote with Enrica Detragiache and Poonam Gupta of the International Monetary Fund a while ago, we looked at what happens to banking systems after a crisis—studying over 35 crisis episodes since the 1980s.

Interestingly, we didn’t see bank lending pulling firms out of a crisis. In fact, even after growth returns, credit growth remains depressed for a while, with firms switching to other sources—internal, equity, bonds, trade credit, and so on, to fund their growth.

This is also true even for the healthiest banks, with financial institutions shifting away from loans to other earning assets. So output often recovers because demand resumes—it is not driven by supply.

This suggests that policies for quick and indiscriminate recapitalization of banks may be misguided. Also, pushing credit and leverage back to pre-crisis levels—though guarantees and the like—may backfire, since the system is usually over-leveraged leading up to the crisis.

Q. Has the response to the crisis contradicted the usual World Bank prescriptions for fiscal prudence and macroeconomic balance?

ADK. There is heated debate saying the financial crisis has shaken the confidence of developing world in the financial and macro policies that underlie western capitalist systems.

Actually, this is the topic of a recent paper Luis Serven and I wrote. For the most part, the confusion arises from not being able to recognize incentive conflicts and tensions between short-term and long-term responses to a systemic crisis.

Policies employed to contain a crisis—often in a haste to reestablish confidence and with inadequate consideration of long-term costs—should not be interpreted as permanent deviations from well-established policy positions.

The fact that governments may end up providing blanket guarantees, or owning large stakes in the financial sector in an effort to contain and deal with the crisis, does not negate the fact that generous guarantees over the long term are likely to backfire.

In many ways this crisis has actually reaffirmed the policy advice we have provided in the financial sector over the past decade. So I would argue the messages in our 2001 and 2007 Policy Research Reports on Finance are just as relevant after this crisis, if not more.

Q. So what has this crisis taught us? What should we change going forward?

ADK. Financial crises often expose weaknesses in the underlying incentive frameworks and the regulation and supervision systems that are supposed to reinforce them. We know finance is a risky business, and regulation and supervision cannot be expected to eliminate crises, but they can and should make them less frequent and less costly.

Clearly something went wrong in the latest crisis. Regulators were not able to exert oversight when it was needed. So understandably there are calls for regulatory reform. Jerry Caprio, Ed Kane, and I have a recent paper emphasizing the role incentive weaknesses have played in leading to the crisis. We propose reforms to improve incentives by increasing transparency and accountability in government and industry.

Q. What role is the World Bank Group playing in the G-20 process?

ADK. The World Bank Group is taking part in four G-20 working groups tasked with tackling and assessing four key areas needed to resolve the current crisis, and to be better prepared to tackle future meltdowns.

These include working groups on enhancing sound regulation and strengthening transparency; reinforcing international cooperation and promoting integrity in financial markets; reforming the IMF; and reforming the World Bank and multilateral development banks.

The efforts of these working groups will feed in to an April 2 summit.